CapStar Financial Holdings, Inc. (NASDAQ:CSTR) Q2 2023 Earnings Call Transcript

CapStar Financial Holdings, Inc. (NASDAQ:CSTR) Q2 2023 Earnings Call Transcript July 21, 2023

Operator: Good morning, everyone, and welcome to CapStar Financial Holdings Second Quarter 2023 Earnings Conference Call. Hosting the call today from CapStar are Tim Schools, President and Chief Executive Officer; Mike Fowler, Chief Financial Officer; Chris Tietz, Chief Banking Officer; and Kevin Lambert, Chief Credit Officer. Please note that today’s call is being recorded. Replay of the call and the earnings release and presentation materials will be available on the Investor Relations page of the company’s website at capstarbank.com. During the presentation, we may make comments which constitute forward-looking statements within the meaning of the federal securities laws. All forward-looking statements are subject to risk, uncertainties, and other factors that may cause the actual results and the performance or achievements of CapStar to differ materially from those expressed or implied by such forward-looking statements.

Listeners are cautioned not to place undue reliance on forward-looking statements. A more detailed description of these and other risks, uncertainties and factors are contained in CapStar’s public filings with the Securities and Exchange Commission. Except as otherwise required by applicable law, CapStar disclaims any obligation to update or revise any forward-looking statements made during this presentation. We will also refer you to Page 2 of the presentation slides for disclaimers regarding forward-looking statements, non-GAAP financial measures and other information. With that, I will now turn the presentation over to Tim Schools, CapStar’s President and Chief Executive Officer.

Tim Schools: Good morning, and thank you for participating on our call. In the first quarter, we reported earnings per share of $0.37 and a return on equity of 8.95%. As you are aware, that return on equity is on very strong capital levels with our tangible equity capital ratio being 9.64% after having repurchased approximately 450,000 shares of common stock during the second quarter. We all more enjoy and wish for economically strong and stable operating environments. As you are aware, this is not one of those environments and I could not be more proud of our team. While we demonstrated in 2020 through 2022 our ability to grow our balance sheet, operate profitable fee businesses as well as improve our NIM and operating expense, the past year, we have shown tremendous discipline in credit and liquidity management.

This quarter, we looked further and identified approximately $3 million of annualized expense reduction opportunities we have already begun to introduce and hope to achieve over the remainder of the year. Mike, Chris and Kevin will provide more detail, but I would like to highlight a few points. First, we were early in our identification of the forthcoming deposit pressures on this same call last summer. Sharing the outlook was challenging, while many banks stated they would grow deposits the second half. With that outlook and the prospects of a credit event, we curtailed investor property lending early last year. Second, we have progressed CapStar in so many ways. One of the areas that remains is funding as CapStar was largely built as an asset generator.

If you study CapStar’s historical funding, a high percentage was comprised of larger, high-cost money market accounts and correspondent banking. Our three community bank acquisitions have balanced our funding profile, but deposits are still a tremendous opportunity for CapStar. Our team has done a great job this year fighting what everyone in the industry has been fighting. We have been working to retain customers and expand customers where there were concerns or we did not originally obtain deposits. On new deposits, the market has been intense, starting in the fall with normal spreads to wholesale alternatives, migrating in January to where banks began offering close to wholesale rates, and subsequent to the termination of the First Horizon deal, where they disrupted the market by offering rates higher than wholesale alternatives.

So, liquidity has come at a cost in this environment, but our deposits stabilized in June and has continued in the third quarter to date. Additionally, our team has lifted our insured and collateralized deposit ratio to over 75% of total deposits from the low 60%-s at the beginning of this year. Third, we have outstanding fee businesses as we have previously exhibited. This environment, however, is not conducive to their historical performance or potential. Combined, we lost about $0.02 per share this quarter pre-tax — well, that’s after tax, I apologize, among our mortgage and Tri-Net divisions. We could have shut them down and reported earnings per share of $0.39 per share. Looking pre-pandemic, in 2019, the same two divisions contributed $0.05 per share per quarter.

That is a $0.07 per share per quarter lift from the current second quarter level or an equivalent of $0.44 per share. Hence, these are very valuable businesses that we believe are an important part of CapStar’s long-term franchise value and worth experiencing a small loss for in the short term. Fourth, our expenses were essentially flat with first quarter as we had a small additional amount for the new stock buyback proposed tax related to the large amount of stock we repurchased in the second quarter. As I previously stated, we challenged our employees from the ground-up, not top-down, to seek expense reduction opportunities, which totaled about $3 million. We want to certainly always be looking for excess and better ways of doing things, however, we do not want to cut to the bone or impair our franchise.

I hope we will begin to see these benefits in the third quarter. Fifth, we have an outstanding credit culture and our current metrics are outstanding as well. We have not done a participation of any type in three years and essentially leave nearly 100% of our relationships. Further, our new loan review — not new. Further, our loan review firm states our top 25 customer concentrations to capital are about half of the industry average. While current metrics are likely not sustainable long-term, they are welcomed along with our strong capital levels in uncertain environments such as we are in. Lastly, we have been proactive in our capital management. Our dividend was increased again this year and is up 120% over the past four years. We also repurchased [453,833] (ph) shares this quarter, and over the past 18 months, have now repurchased about 1.5 million shares or about 7% of CapStar’s total outstanding shares.

In our newest authorization, we communicated capital targets. Personally, I believe our stock is cheap. Our tangible book value adjusted for AOCI is $16.95 per share. We have a small relative securities portfolio; it is all held and available for sale. We have strong insured and collateralized deposit levels. We have ample liquidity. We have strong credit. And we have strong capital. Therefore, there is more opportunity to return capital essentially — excuse me, especially at our current stock price, but it is prudent to abide by these capital targets to be conservative at the moment. As you can see, a tremendous amount of hard work has and is being put in by our employees as we work to deliver an outstanding customer experience and strong shareholder results.

I’ll now turn it over to Mike.

Mike Fowler: Thank you, Tim, and good morning, everyone. I’ll touch on a few key performance highlights, starting on Slide 8. As Tim noted, we continue to navigate through a very challenging operating industry for CapStar and the industry, mindful of near-term profitability, while also maintaining a longer-term view regarding issues such as franchise value and retaining and attracting profitable customer relationships. We focus on four key drivers of profitability: First, we target annual revenue growth greater than 5%, which has been challenging in the current environment given headwinds for net interest margin and several key fee businesses. Second, we target a net interest margin of 3.6% or more. Chris will provide more color in a minute on both sides of the balance sheet.

So, I’ll note that the NIM peaked at 3.50% in the third quarter of last year. And as we’ve seen throughout the industry, our margin has declined in recent quarters due to deposit pricing pressures, falling to 3.06% in the current quarter, and we could see further modest downside in the next quarter or two. Number three, I would direct you to Slide 16, we target an efficiency ratio of 55% or less. The second quarter ratio was 66.6%. We did achieve or were near our target for several quarters in 2022. Reaching our target, again, will require movement on both revenue and expenses. As Tim noted, we expect to see material improvement next quarter having identified approximately $3 million of annualized expense reduction with partial implementation in late June, and the remainder expected to be implemented through the rest of 2023.

We always strive for expense discipline, and in the current environment, we will be — we will have very limited hiring with an increased emphasis on improved efficiency. Fourth, we target annualized net charge-offs of less than 25 basis points. Kevin will review credit in a few minutes. So, annualized net charge-offs of 3 basis points for the quarter remain unchanged from the prior quarter. Next, I’ll shift to capital briefly on Slide 17. As Tim noted, we maintain strong capital levels, while continuing to execute a balanced strategy for deploying capital. Chris will comment shortly on how we’re managing organic growth opportunity in the current environment. Second, we generally target 20% to 30% dividend payout ratio. And in the second quarter, we announced a 10% dividend increase.

Third, as Tim noticed — as Tim noted, we have purchased shares year-to-date through June, 920,000. When in May we announced completing the $10 million buyback program and authorization of the new $20 million buyback program, as Tim noted, we announced our intent to maintain above industry capital levels with target tangible common equity of 8.5% and target common equity tier 1 ratios of 12%. Our TCE remains a solid 9.64% despite 166 basis point drag from AOCI. And as Tim noted, a 100% of our investment portfolio is classified as available for sale. So, all realized — all unrealized losses are reflected in TCE. Balance sheet strength is always a top priority, both from the perspective of capital and liquidity, and especially in the current environment.

A few brief slides on liquidity, turning to Slide 5. We have $1.5 billion of on- and off-balance sheet liquidity sources. And our bankers have been very proactive with current and potential depositors, discussing alternatives to maximize FDIC insurance in the wake of SVB in order to reduce the risk of runoff over safety concerns. As Tim noted a minute ago, you can see on the bottom left chart, we have increased the percent of deposits, which are either insured or collateralized from a strong 66% as of Q1, up to 76% as of 06/30. I will now turn it over to Chris.

Chris Tietz: Thank you, Mike. I’ll be touching on the content of a number of slides to give you insight into the drivers and challenges we have across our diverse revenue spectrum. I’ll be offering you insight into where we are and how we intend: first, to address deposits and deposit growth; and second, to manage loan growth and assure adequate yields to enhance our net interest margin; and then finally, I’ll give you insight into our fee businesses and help to define expectations there. Given the precious nature of deposits, let’s start there. We entered the quarter on the heels of the mid-March failures of Silicon Valley Bank and Signature Bank, followed by the emerging issues with First Republic Bank in April and their failure on May 1.

Then on May 4, the TD merger with First Horizon was called off. With this, there was a confluence of two very different dynamics that we had to confront competitively: first, the generalized market concern over industry stability; and then, the competitive considerations of a large local competitor becoming hungry for deposits to enhance their liquidity, which has become tight, leading up to the planned merger. We are very proud of our team, especially our bankers in our community markets. While our slides give you quarter-to-quarter comparisons, right now it’s important to understand what happened within the quarter. First, as shown in the slides, we achieved net growth in quarter one for customer deposits of about $30 million. This is shown on Slide 4.

Also on Slide 4, you’ll see the customer deposits declined $75 million between March 31 and June 30. The nuance into the second quarter decline with the backdrop of the confluence of events I mentioned earlier is revealed in review of month-end balances. Our end-of-period deposits declined $76 million in the month of April and another $41 million by May 31. In June, we turned this around with $41 million of growth, and we are very pleased with continued improvement so far in July showing strong growth on track to exceed June. Needless to say, as Tim indicated earlier, this came at a cost as we have often needed to match the deposit rates of highly-motivated competitors and this resulted in reductions in our net interest margin that I’ll talk about in a few minutes.

But first, let me tell you what we are doing. First, incentive plans are modified to place emphasis and priority on core deposit generation. Second, we are focused on building a culture of avoiding the commodity trap of being price-only competitors and seeking to understand and meet needs with the deposit products we sell continuing to leverage our sales of our superior treasury management services. We underscore these aspirations by driving this point home to our team in our daily oversight activities and our weekly pipeline meetings. And finally, we intend to reward our deepest and broadest relationship profiles with the best lending rates we have to offer. On lending and loan growth, touching on Slide 9. First, as Tim has mentioned in past calls, we have had an extraordinarily high loan prospect pipeline, but we lacked an equally large deposit prospect pipeline.

Therefore, we have intentionally reduced our rate of loan growth as we shift our emphasis to quality funding and expansion in solution-based depository relationships. In this period of shifting fundamentals for success, it is our intent to focus on quality of growth rather than quantity of growth. Our emphasis will be on expanding share of wallet with existing customers, and holding ourselves to the expectation of growing our deposits faster than loans overtime. This emphasis will come in a number of tactics. We have established elevated yield expectations with pricing benchmarked to matched FHLB funding rates. As a side note, I’ll note that spreads to funding costs were much higher when I started my career nearly four decades ago. Over the last 10 to 15 years, expected spreads have narrowed, but I think our industry will see widening spread expectations in coming years.

These higher yield expectations in current markets would result in us pricing loans in a range of 7.25% to 8.25% range depending on term, risk and the depth of the borrowers’ non-credit relationship with us. The position in this range would be highest for a loan-only relationship and lower based on the share of wallet we have in the customers relationship with us. These targets will be applied to renewing loans and any new loans. It should be noted that about 25% of our loans have a maturity within the next 12 months. Some of these loans will complete a scheduled amortization and payoff. Of the loans renewing, fixed rate loans will be priced into our target range, and variable rate loans will be evaluated to assure ample spreads. Pricing enhancements will be available to customers who expand their non-credit relationship with us by moving balances and fee business from other competitors.

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Competitively, we may lose some existing balances in the lower end of our current yield spectrum. But in doing so, we intend to redeploy this funding to relationships meeting our strategic targets. We’re not quite there yet. On Page 9, you will note that our new origination yields in the second quarter were nearly 7.8% and near the range we are targeting using FTP protocols as a benchmark for cost of funds. We believe this will enhance our net interest margin, but it will take time in a market challenged by tight liquidity. So, let’s talk about net interest margin and expectations. As noted earlier, our deposit balances are stabilizing and starting to grow again. In the fiercely competitive marketplace, I hesitate to make a prediction on deposit costs for the near term future.

However, I note that one large competitor in our marketplace indicated earlier this week that they expect to be less aggressive in pricing deposits in coming months. In addition, it appears that First Horizon was successful in their fundraising campaign in the second quarter and this may assist in settling the unexpected spike that occurred with their aggressive pricing posture. Relating to loans, as noted on Page 10, yields are improving and, as I mentioned earlier, we will have an opportunity to address pricing as needed on up to 25% of our portfolio that matures in coming quarters. In addition, we have unfunded commitments with expected funding in the yield range we’ve noted and we believe that this will continue to enhance our overall yield to mitigate higher deposit cost.

In short, while the pressure will continue, we will actively work to manage the variables within our control. One other tactic that I want to note relating to net interest margin isn’t specifically referenced in the slides. As some may recall, with our merger of Athens Federal community bank a few years ago, we added their consumer finance subsidiary, Southland Finance, to our business lines. Southland is a secured consumer finance company with average loan sizes in the $4,000 to $6,000 range, and it’s operated for over three decades with one branch in Athens, Tennessee. Several years ago, Athens Federal opened a second branch in Cleveland, Tennessee that we relocated to a new high visibility location in the last several weeks. The business model is simple.

The yield is about 25%. Their losses are relatively low and consistently offset by loan fees. The non-interest expense is about 15% of assets, and the resulting pre-tax ROA is about 10%. Right now, their portfolio is small, but their overall contribution to annual earnings is about $0.02 to $0.03 per share each year. The reason I’m highlighting this subsidiary for the first time is that we are excited to let you know that we opened our third Southland branch in Chattanooga on July 3 and it’s off to a great start. It’s already achieved its six month growth goal in the first two weeks of operations. We will watch this location’s development closely as we use it as a benchmark for gauging the benefit of further expansion, leveraging their efficient delivery of high yield secured consumer paper to enhance our net interest margin.

Finally, let me focus on some key fee revenues, as noted, starting on Page 13. Let’s start with mortgage. This is as challenging a time as any seasoned mortgage lender has seen in their career. While CapStar operates in a robust housing market and we have a good market share for mortgage originations primarily in the Nashville MSA, higher interest rates have limited both volumes and spreads on sale. It should be noted that Nashville area volumes are in line with activity levels not seen since 2014. When we consider the appreciation in the housing market since then, it underscores that the number of transactions is actually down substantially since 2014. As noted on Page 14, we remain committed to a model primarily focused on purchase money transactions rather than the more volatile refinance market.

While volume in the second quarter was higher, margins were lower. We believe that there will be a competitive shakeout in the marketplace that will offer opportunity for us to expand our capacity and leverage our skilled mortgage delivery team by layering on more origination capacity. Our guidance is to maintain expectations at current levels in the near term until we see a break in interest rates. As to Tri-Net, after record volumes in prior years, Tri-Net remains mostly on the sidelines. We are pleased to see opportunities emerge on a handful of transactions that allowed us to make a little revenue in the second quarter. We’ve adjusted our model to originate to presales-only targeting transactions where we have identified a buyer before closing.

This business has historically been driven by 1031 exchange money. I’ve seen recent statistics indicating that 1031 exchanges are down about 65% for lack of motivated sellers. The limited volume that we observed in the marketplace is generally landing with either a bank that will price its spreads close to treasuries or to cash buyers. We are committed to doing this profitably and we will not compete with low price competition, as our value proposition has always been speed to execute and reliability to close. Our guidance is that Tri-Net revenues will remain low in coming months. On Page 13, there is an appearance that SBA revenues are down quarter-to-quarter. There are some relevant factors to consider when assessing this. First, please reference Page 15 to see the larger trend that includes the various components of recurring income in addition to the net fee revenue shown on Page 13.

Second, there are two types of originations that occur in the SBA space: loans with close that are available for immediate sales; and loans with deferred funding like a construction loan where the project needs to be complete before the guaranteed portion is saleable in the secondary market. In addition to this, there are two ways of sourcing transactions: transactions directly sourced by one of our business development officers; or transactions working with a referral source who has paid a referral fee for the transaction when it closes. This is relevant for two reasons. We made our origination targets for the first half of this year, but a substantial amount of that volume in the first half was in transactions with delayed funding characteristics.

Under the current arrangement with our referral sources, we pay the referral fee at closing even though the gain on sale will not be recognized until construction is complete generally six to nine months in the future. Thus, we unintentionally create a timing difference that front-end loads the expense without the revenue. The approximate impact of this in the second quarter is about $150,000 to $200,000 of front-end loaded expenses without an offsetting revenue. Thus, you see the reduction in net SBA lending fees noted for the second quarter on Page 13. But there’s an upside. At June 30, the anticipated gain on sale from loans closed in the first half of the year, for which the referral fees have already been paid is approximately $1 million and this is in addition to normal production levels that we expect to continue into the third and fourth quarters.

This will enhance our revenue at higher levels in the last half of 2023. In general, my guidance is to expect higher gain on sale revenues over the balance of the year than we’ve had in the last two quarters. But, because of the inherent complexities of managing the timing to recognition of the gain on sale, I hesitate to give specific guidance parsing between the third and fourth quarters. In short, we are very proud of what this SBA team has accomplished in a short period of time. Their efforts are evident with their placement as the 49th largest originator in the 7(a) SBA program based on the nine months ending June 30. We are very pleased with the results and the trend of growth that they’ve established. Finally, there is one other fee business that I want to highlight as an example of how we seek to grow revenues.

Another business that we obtained through the Athens Federal merger is Valley Title. They are a title agency located in Athens, Tennessee. While small and contributing about $0.01 per share to earnings annually, we are targeting it for growth as we seek to get a bigger share of earnings from our own transaction closing volumes. We are evaluating ways that Valley can do more on CapStar originated transactions, particularly higher gain commercial transactions secured by real estate. This will include an expansion of licensing to multiple states over time, so that we can capture a bigger share of cost that we would otherwise outsource to other agencies. While the overall contribution is small, their pre-tax earnings through June are five times what they were for the same period last year despite reductions in overall mortgage activity levels.

I’m not offering this to suggest that you should modify your guidance in any way, but rather to underscore our commitment to evaluating everything we can whether big or small to offset the NIM compression that will challenge the industry for the foreseeable future. This concludes my comments on revenue. And with this, I’ll turn it over to Kevin to discuss asset quality.

Kevin Lambert: Thank you, Chris. We are very pleased with the excellent second quarter credit results for the bank, as detailed on Slide 11, which continue to indicate a very sound portfolio. Past dues of 15 basis points are near a five-year low for the bank and this is also true with the bank’s criticized and classified loans, which totaled only 1.36% of the portfolio at the end of the quarter. We had a somewhat unexpected payout for one of our largest substandard loans during the quarter as well as an upgrade to a pass on a special mention relationship that has always performed well. In total, the bank reduced its criticized and classified loans by an outstanding 25% during the period. While non-performing assets ticked up slightly to 48 basis points, two relationships totaling $8 million in this category are expected to be upgraded and return to accrual status during the upcoming quarter.

While there’s always inflows and outflows to loans in our risk rating categories, we’re very happy with the positive movements during this quarter and the prospect of even better results during the next few months. As could be expected with the low past dues and minimal level of substandard loans, the bank continues to have a very low level of charge-offs, as Mike mentioned earlier. The second quarter percentage of only 3 basis points was identical to the ratio reported in the first quarter and is much lower than the target of 25 basis points that we try to adhere to. Beginning over a year ago, we started tightening CRE guidelines and the portfolio continues to perform very well. Presently, the bank has no large CRE loans, none over $500,000 that are not pass-rated.

All loans are routinely stressed at origination and renewal. We continue to monitor our portfolio for signs of weakness. We continue to avoid speculative real estate construction projects and remain focused on maintaining a balanced loan portfolio with the current emphasis on C&I and consumer lending. Our markets continue to be vibrant and we believe that our portfolio is well positioned in the event of an economic downturn. In summary, management is very pleased with asset quality metrics this quarter with extremely low past dues and charge-off percentages and an overall reduction of 25% in special mention and substandard loans. Also, we recently completed one of the bank’s biannual loan reviews as well as our annual safety and soundness exam, and we are very pleased with the results.

While we are not permitted to disclose specific ratings from the exam, the regulators did concur with their credit ratings for all loans reviewed, and we had no downgrades. Again, just a great quarter for the bank. Tim, I’ll turn it back over to you.

Tim Schools: Okay. Thank you, Kevin. We appreciate everyone’s support as we continue to work hard to provide great service to our customers and ensure we protect the financial soundness of the bank. That concludes our presentation, and now we’re happy to answer any questions.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from the line of Will Jones with KBW. Your line is now open.

Will Jones: Hey, great. Good morning, guys, or I guess good afternoon at this point. How are you guys?

Tim Schools: Doing good. Thank you. Good morning.

Will Jones: So I just wanted to start on expenses. I know they came a little bit higher than your guidance from last quarter, which I think was $18 million to $18.5 million or so. But it was good to see the cost savings plan announced. And I know you guys really like to focus on the expense to average asset ratio. But just as you think about where expenses need to be in this environment relative to the challenged revenue outlook, where do you feel like that ratio really needs to be? And does this cost savings plan and get you there?

Tim Schools: Well, I think mathematically — this is Tim. So I think mathematically, I’d love to run a bank that the efficiency ratio is 50% to 55%. I think that’s a healthy range where you’re prudent, but you’re not overly frugal. I think we’re in a revenue compressed environment. Like I said, we could improve our efficiency ratio immediately by shutting down mortgage in Tri-Net. So, I think it’s a good question to ask, but it’s a very unusual environment. So, I guess, I’m thinking more — I don’t think this is a period to manage to the efficiency ratio or to the expenses to assets, I think it’s a longer-term thing to monitor. It feels to me that, like I said last quarter, I would have hoped it would have come in, in second quarter.

We were a little late, to me, in delivering these where I would have liked to, but I still think we can see our expenses come to those levels we talked about. So, I’m hopeful and optimistic that this quarter, you’ll see those come through. And hopefully, the second half of the year, we began to operate more closer to the $18 million a quarter range until revenue returns. And many of these are ideas that were submitted from the bottom up are sustainable long-term things that even when revenue returns, certainly, you’ll have commissions and incentive plans, there’ll be an expense growth along with some of that revenue, but some of these are permanent revenue ideas. I was very pleased with the suggestions.

Will Jones: Got you. That’s helpful. So it’s really — it’s kind of fair to assume that you guys will exit the year at a lower expense run rate than what we’re seeing in the second quarter?

Tim Schools: That is my expectation, and that is my hope.

Will Jones: Great. And then, I don’t want to pin it any ’24 guidance or anything, but if we exit the year at a lower rate and then you just kind of think annually 2024, could — can ’24 expenses really be flat with ’23 or maybe even down? Or how do you think about this longer-term expenses?

Tim Schools: Again, some of it’s hard — we’re in such a drastic unusual environment right now, and I would think every bank is, because this would be in line with my previous banks. I mean, right now, sales incentive plans are going to be down, corporate incentive plans are being accrued at lower levels, we have no mortgage commissions. So, a lot of it is you look at the outlook for rates and you hear some folks saying that, “Okay, rate cuts may begin January 31.” I saw it was possibly the earliest next year. Some people say it’s later. Well, if rates come down, we really think there’s going to be an immediate refi in the mortgage market, and we think we’re well positioned for that. So, our revenue would shoot up, but our expenses would go up.

So, I’m not trying to shy away from your question, but I don’t think there’s an easy answer. I guess here’s how I answer it, is if we stayed in a — if we stayed — if the economic environment stays as is through ’24, I would hope that our quarterly expense level goes closer to ’18, and it would not be out of line to think that it couldn’t stay generally in that range all of next year. If rates go down beginning next year, I hope that is our underlying base with some permanent savings, but I think sales commissions and certain incentive plans will go up as a percentage of revenue. There certainly would be operating leverage because it wouldn’t be the full amount, but you’re not going to get the revenue gain without some expense growth. I don’t know if that makes sense or helps.

Will Jones: No, that’s very helpful. And I know there’s a lot of puts and takes to that question, so I appreciate that kind of guidance there. And I guess just maybe switching gears to the buyback. I mean, you guys are looking for the past two quarters have been active around the $6 million to $7 million range. You did it this quarter, keeping TCE really flat and CET1 really — CET1 maybe the governor for buybacks going forward here. But to the extent the stock stays cheap, Tim, it sounds like you’re very motivated by the valuation here. Did the buybacks continue at the same clip? Or could we see a more active pace of buybacks going forward? Just how are you thinking about it here?

Tim Schools: Well, we put a release out. And I don’t think immediately — I wouldn’t expect third quarter will be the same level as second quarter. But as I said, I mean, our adjusted — if you would — everybody views it differently, but we have a very small securities portfolio. Everything I said, our insured deposit levels are high, the likelihood of us having to sell our securities portfolio is very low. And so, I know that’s GAAP accounting, and I know it’s marked in there on our tangible book value, but our tangible book value, I don’t have it right in front of me, is something like $14.60. And if you adjust for the AOCI, it’s almost $17. So I just think our stock is cheap, no matter how you look at it. You can argue what you think the value is, but I just think it’s cheap.

And I would be a buyer of the stock, but you’ve got lots of concerns out there. The waters are as choppy as I’ve seen in my career, in that there’s multiple waves at once. There’s deposit pricing pressures. There’s liquidity pressures. Now they seem to have subsided in June and July. People continually talk about the credit cycle and whatever. And so, we would never want to be in a position — we wouldn’t want to be greedy to get a little accretion at the risk of ever having to dilute a shareholder if you had to do a capital raise. And it wasn’t right before the National Capital test just came out, the stress test, there was a lot of talk about banks were going to have to raise capital, U.S. bank and other banks. And we’ve never been in that conversation.

But I would say to say here in the immediate short term, probably a little less, but I think those same levels are still available. I think that it appears to me the economy is slowing down. People are borrowing a lot less. We have people delaying projects. We have people using their cash and their earnings to pay down loans. So, I think the ability of our profit is going to build up capital. So, there will be big potentials to buy back stock at good prices. Just like to see a little bit clear water before we go as much as we had.

Will Jones: Very thoughtful. Thanks for the color there.

Tim Schools: Sure. Thank you for your questions.

Operator: Thank you. Our next question comes from the line of Brett Rabatin with Hovde Group. Your line is now open.

Brett Rabatin: Hey, good morning, guys.

Tim Schools: Good morning.

Brett Rabatin: I wanted to start with loans and just wanted to get a better understanding. You talked about the loans repricing and FTP spreads are nice to see. The improvement in the loan yields were a little lower this quarter than last quarter. Can you talk maybe about the magnitude of the change in the loan yield from here? And how you think that plays out relative to the current rate environment?

Tim Schools: Yes, I’ll let Chris cover that, but I want to point one thing out before he gets into that, just to let everybody know what we’ve seen, and I think everybody talks about this differently. We internally and at my former organizations, we always targeted loan yields to FTP matched funding rates. So if you had no deposits, you had to go to the FHLB and fund that loan, what would that borrowing be from FHLB? So, when we talk about our spreads, the spreads we’re talking about are not to our current actual deposit rates. So, I just want to be clear on that. But historically, where I’ve worked, we’ve targeted a minimum of a 200 basis point spread on commercial loans. And if you do that sort of on a napkin and put in a tax rate and a provision and some reasonable operating expense, if you really don’t get 200 basis points, you’re not going to get a 1.30% ROA.

So that’s sort of a floor we always targeted. In the fourth quarter of ’21, we reported to you all that our FTP spread was 250 basis points, in the fourth quarter of ’21. In the first half of last year, we reported to you all that our FTP spreads were in the 150 basis point range. And the reason for that was wholesale rates had shot up and we communicated at that time that competition in the markets either were stretching for loan growth or they were less sophisticated and they didn’t raise their pricing. So if you wanted loans, you had to jump in the game with them. It was almost like the inverse of the deposit market today. So, if you want deposits today, you’ve got to pay what First Horizon is paying. It’s irrational, but you’ve got to pay it.

Well, it was the same thing for loans first half of last year. So it was 250 basis points, then it was 150 basis points. So, I’m really pleased that in this environment, we’re getting closer to the 290 basis points to 300 basis points. So, we’re getting better pricing to help mitigate the sharp increase in deposits. But I’ll let Chris talk more specifically about your question.

Chris Tietz: Yes. And Brett, thanks for the question. I want to clarify, are you looking at on Slide 10, questioning the direction or the trajectory of the loan yields, or the actions that we’re taking?

Brett Rabatin: No, Chris. Actually, the — if you look at the loan yields on Slide 10, actually, just the linked quarter change, 2Q versus 1Q, was less than 1Q versus 4Q. And I know rates were moving up faster in 4Q than they were this quarter. But just wanted to make sure…

Chris Tietz: Got it, okay. Yes. Okay. Well, I don’t have specific dates in terms of when we had Fed increases and so on. But we have a number of situations where timing in the quarter would matter where we’re repricing a renewal. Not all loans reprice today that in index changes, some might change quarterly in. Let me turn it over to Mike. He can give you more insight on that than I can.

Mike Fowler: Brett, good morning. This is Mike. Just a quick comment on the moving to market rates, which would drive change in loan yields, both existing and new. So, if you look at the Fed effective rate, the Fed funds rate Prime is sort of — continues to be 300 basis points over that and other short-term floating rates are also very closely linked to that. We saw in the first quarter, 104 basis point increase versus the fourth quarter in terms of the average Fed effective rate. If you recall, into late last year, the Fed was hiking rates very aggressively. 10 consecutive meetings. I think it was three meetings in a row, they hiked 75 basis points. Early this year, they intentionally slowed the rate of growth. And so to a point that Chris made a second ago, the rate of market rate increases on the short end, slowed considerably in Q2 from 104 basis points Q1 versus Q4, down to 30 basis points second quarter of this year versus first quarter.

And then that would have translated into less of a pickup on the loan yield.

Brett Rabatin: Okay. That’s helpful. And then, I wanted to go back to the expense reduction and just maybe talk about, Tim, if you could, the areas that you’re getting more efficient in some of that mortgage lines of business, where you’ve been able to reduce your expense base?

Tim Schools: I mean really — I’ll just comment first. It’s really the way we did it is, my reports, we labeled the Executive Committee, their reports, we labeled the Leadership Council. And really, Mike Fowler and Lynn Rhodes met with every member of the Leadership Council and just said, “Hey, here’s what’s going on out there on revenue, and we’re not hitting our budget on revenue, and we’d like to offset a little bit on expenses.” And so everybody brought something to the table. So, I probably should have been better prepared to have that list in front of me, but there’s an aspect of people where whether they’re producers or their back-office people, if volumes are down or people aren’t producing, you haven’t really done layoffs, but not replacing through attrition.

And then there was a lot of vendor stuff where there’s dual vendors or there’s things we don’t need. So I don’t have a specific talk in front of me, but there was a broad array. One thing we did do that had not been in place as a small company is CapStar did not have a branch staffing model. And so, if you think about Whole Foods, Starbucks, McDonald’s, any retail environment, every larger bank I’ve been in, there’s a branch staffing model. Everybody is slightly different based on how many tellers you need or personal bankers or branch managers. We rolled that out this quarter, and I believe through attrition that, that was 12 to 15 individuals, again, not layoffs, but just through normal attrition and reallocating people.

Brett Rabatin: Okay. And then just last quick one. I would assume that loan growth is more like a mid-single-digit kind of number going forward, just depending on what you have in the pipeline.

Tim Schools: Yes. So I mean, again, in our market, if we wanted to grow — I bet you — first of all, there’s a large reduction in demand for loans at the moment. And I’ve visited a lot of customers in the past. I mean — but they’re out there. I just visited a customer the other day that’s buying a piece of property and already an existing customer has I think $12 million with us and wants to borrow $2 million more. So I mean it’s out there, but the demand is a lot lower. We’re in great markets. We’ve got great bankers. I would think today if we wanted to, we could probably grow 5% to 10% annualized with deals we lead, not buying former deals. Some of that would be CRE, which I don’t know is prudent. And I think until the liquidity scenario is clear, I hate to do that in the short term.

So, I feel really good that we have a bank in markets that we can grow loans 10% to 12% long term. I don’t think this is a market that any bank thinks they can grow their funding 10% to 12%. So for me, if I was modeling this year in 2024, I probably would do at that 5% or lower.

Brett Rabatin: Okay, great. Thanks for the color.

Tim Schools: Sure. Thank you.

Operator: Thank you. Our next question comes from the line of Kevin Fitzsimmons with D.A. Davidson. Your line is now open.

Kevin Fitzsimmons: Hey, good morning, everyone.

Tim Schools: Hi, Kevin.

Kevin Fitzsimmons: I appreciate all that color talking about the drivers of the margin, but just maybe kind of going from a very top level, you did say you expect further pressure. But would you — is it fair to say you would expect further pressure over the next few quarters, but perhaps at a diminishing pace relative to what you saw in second quarter? Is that a fair or reasonable outlook that you would model?

Tim Schools: Let me say something, I’ll let Mike dig into the true mechanics, because to me, I can say the 30,000-foot. Some of it is out of our control. I mean, I can tell you, First Horizon caused a lot of Tennessee bank margin compression this quarter. I mean, I don’t — they went probably 0.25% above wholesale rates. None of us expected to do that. There were people offering CDs at 5% and 5.05% and then they came out at 5.50%. So, it’s hard to give you an exact answer. This environment is so unusual. I think theoretically, what you say makes sense. You would hope your most elastic depositors were early movers or early people asking for rates. Number two, you would hope the pace of increase in rates from the Fed is slowing down.

So, I think everything you’re thinking about sounds right, but there are irrational and other competitors out there you don’t control, and it’s a very transparent market. People have the Internet, they have newspaper, there’s word of mouth. So, Mike, I don’t know what you want to add in addition to that.

Mike Fowler: Sure. [Technical Difficulty]

Kevin Fitzsimmons: Okay. Great. Thank you. And perhaps one, you mentioned about having a small securities portfolio, Tim, and — but also mentioned the impact of AOCI. So, would you look at any small targeted type transactions of the bond portfolio to put some of that — some proceeds to work at higher rates, or is that maybe not a smart move long term, you’d rather just let those securities cash flow?

Mike Fowler: Sure, Kevin. This is Mike. I would say near term, I mean, that’s always something that we could consider. I would say near term, we’re letting — we’re continuing to let the portfolio run down modestly. We’re continuing to prefer to put any asset originations in terms of appropriately priced loans in market loans. So, no, we’re not expecting near term to be increasing the size of the investment portfolio at this time.

Kevin Fitzsimmons: Okay. That’s great. Maybe if we can talk to DDA shift that the whole industry is seeing, like on one hand, Tim, you mentioned about the long-term challenge with funding. So on one hand, CapStar started out from a lower point, right, in DDA contribution in terms of this mix shift. But it looks like it’s fallen below even like the year-end — the pre-pandemic year-end ’19 level in terms of percentage, if I’m looking at it right. And I’m just wondering if that — if you’re seeing that slow? And it’s a tough environment to change that dramatically, but when you look, is it really going to come down to longer term when there’s opportunities to maybe buy small banks that, that’s when you can really make big progress on that front in terms of buying small, really deposit-heavy type banks? Or — I’m just trying to connect the near term and the long-term aspirations on that front. Thanks.

Tim Schools: Yes, it’s a great question. We actually had an investor last quarter, say, “Hey, gosh, your DDA has really declined a lot.” And for CapStar, you have to look under the covers because that comment was not accurate. I can see where the question would come from. But our incremental funding at the last 12 months has really been brokered CDs. So, when you look at the current total deposit mix today, you’ve got $400 million to $450 million of CDs that you didn’t have in the mix in 2019. So, I can send you a chart, if you take the time to normalize, excluding brokered CDs, the percentage of DDA is actually the same. It was 19% of funding before, and it’s 19% of deposits today, it’s identical. I would say, at CapStar, probably wasn’t — what was transparent before is when you went pre-pandemic, rates were really low.

A lot of those DDAs were related to correspondent banking and they needed to hold those — they had high-priced money markets with us and they needed to hold a certain amount of DDA to cover their Fed charges. Now that rates are higher and ECR earnings credit rates are higher, they need to hold less DDA today to cover their fees. So, I would actually argue that our DDA, while it’s the same percentage of 19 and 19, it’s actually stronger, because we would have less correspondent-related DDA because some of it would have moved out with the higher ECR, but we can send you this chart. But it’s a great question, because on the surface, if one didn’t know that CapStar had funded with brokered CDs over the last year, you would think, “Wow, what happened with the mix shift of DDA?” But the actual dollar balances as a percent of the total are holding flat.

Mike Fowler: Yes, Kevin, this is Mike. One thing I would add briefly, Kevin, is that with the Fed expected to be near the end of its hiking cycle, I think, to Tim’s point, some of the pressure that we and the industry will feel on the shift out of noninterest-bearing DDA should subside. So, we certainly hope and especially with the focus on core operating accounts and customer deposits, we certainly see pressure there easing. So hopefully, we will be near the trough. And as Tim said, we’re back to the 19% of non-broker deposits we saw pre-pandemic when Fed fund was at 25% versus 5.25% today.

Tim Schools: So you would think a lot more people are chasing 5.25% today than they were a quarter back then. So, I think it’s good that the number is the same and a much higher rate environment. But the brokered CDs, when you throw that in, makes it look like the percentage went down.

Kevin Fitzsimmons: That’s a great point. Thank you for clarifying all that, Tim. Great. Thank you.

Tim Schools: Thank you for asking.

Operator: Thank you. Our next question comes from the line of Feddie Strickland with Janney Montgomery Scott. Your line is now open.

Feddie Strickland: Hey, good morning, everybody.

Tim Schools: Hi, Feddie.

Feddie Strickland: Just wondering if you could provide the expense number for the mortgage division or the bank expenses ex mortgage. And then along that same line, does some of the cost saves come from the mortgage side? I apologize if you covered that earlier. We were just trying to think through the expense line for that division.

Tim Schools: Yes. I don’t want to get into specific areas, but I’m sure there are some from them, really every department across — every department in the company contributed. So, I’m confident there’ll be some there. But maybe Chris could speak up as to what the bank — excuse me, what the mortgage division expenses were in second quarter?

Mike Fowler: Yes. For the second quarter, I’ll quick comment, and then I’ll let Chris add, the mortgage expenses were $1.5 million in the second quarter. And they are down about $320,000 from same quarter a year ago due to some of the actions — due to some of the incentive declines, but also due to some proactive management of expenses. And Chris is in the mortgage business.

Chris Tietz: Yes. And Feddie, I’ll point out, we have historically been a top five or top 10 originator, particularly in the Nashville MSA. We believe that that’s a franchise that has value, particularly with the robust — given that we do purchase money transactions, not refi, we believe that that’s an important franchise. And so, as I indicated earlier, while we have paired some overhead in the mortgage group over the course of the last handful of quarters, including recently, our primary objective right now is to leverage the skilled team and the overhead we have with more origination capacity and that will either work or won’t, and then we have the discretion of addressing that if it doesn’t.

Feddie Strickland: Understood. That makes sense. That’s all I had. Thanks for the color guys.

Tim Schools: Thank you, Feddie.

Operator: Thank you. And I’m currently showing no further questions at this time. I would like to turn the call back over to Tim Schools for closing remarks.

Tim Schools: Okay. That’s all we have. We appreciate everybody, and hope everybody has a good weekend. Thank you.

Operator: This concludes today’s conference call. Thank you for participating. You may now disconnect.